Here’s a confession: I’m still not 100% sure exactly how much money I should have in my emergency fund.
Sometimes I find myself wanting more, realizing that life can be chaotic and unpredictable and it’s good to have a margin of safety.
Other times I’m frustrated with how much cash is just sitting fallow in a savings account, losing purchasing power to inflation. It’s money that could be earning money if it were invested wisely.
This inner debate is a constant dance between two emotions that are always front-and-center where money is concerned: Fear and greed.
I’m not sure I’ve found the perfect balance, but here’s how I think about the issue of how much you should have in an emergency fund.
What’s an Emergency Fund For?
First things first, we’ll state what should be obvious: An emergency fund is only for emergencies
This isn’t any account you should find yourself routinely dipping into.
Of course, now we have the problem of defining what an emergency is, and I can’t do that perfectly. In some cases, it’s obvious. If your salary is your family’s sole source of income and you lose your job, that’s a financial emergency. You should devote your time to looking for a new job and use your emergency fund to cover your basic needs.
Likewise, some things are clearly not an emergency. A major sale on some big item you want to but may be urgent, but it’s not even close to being an emergency.
There’s a space in the middle where things aren’t so clear. Does unexpected car trouble count? Should you have saved for that somewhere else? Good questions. I think you can answer them how you want, but make sure you’re on the same page as your spouse.
But it’s important to remember that however much you put into this fund, you’re intending to keep it for emergencies. Anything else you want to save for should be in another account and will involve saving additional funds.
Measuring in Months
The real way to measure your emergency fund is not by the raw value of dollars in the account, but by how many months of living expenses that money can cover.
Of course, this means that you’ll need to track your spending to know how many months your emergency fund is worth. If you aren’t already doing this, I recommend a free tool called Personal Capital. This is the tool that I use and love. It’s so good that it replaced my spreadsheet; and I’m something of a spreadsheet nerd. Check out my guide to see what else Personal Capital can do.
So how many months should you have set aside? The general recommendation is 3-6, and I think this is pretty good.
But of course, that recommendation is a range, not a specific amount. Should you have three? Five? More than the recommended range?
Let’s look at the factors that might steer you one way or another.
The Factors That Count
There’s basically just two things that matter when figuring out how much to stash away for a rainy day:
- Your current level of risk
- Your risk tolerance
A high level of risk warrants a large emergency fund. So does a low risk tolerance. A low level of risk combined with a high risk tolerance tends to suggest you can get by with less.
Let’s take a closer look.
Factors that Increase Your Risk
Having a High Cost of Living
The bottom line here is that a cheaper lifestyle is less risky because it’s easier to fund.
You might say that measuring the emergency fund in months instead of dollars corrects for differences in spending, and you’d be right. But you’re forgetting the income side of the equation. If you’re making and spending $10,000 a month, you have more risk than someone making and spending $5,000 because it’s easier to come up with $5,000 a month than $10,000.
The harder it is to generate enough income to pay for your living expenses, the riskier your situation is.
A Lack of Flexibility
Your expenses may be high, but how quickly can you lower them?
If you have a flexible situation where you could easily move somewhere cheaper or sell your car if needed, you have more of a margin of safety built in.
On the flip side, if your lifestyle and costs are more inflexible, you have more risk.
Having Few Sources of Income
All of us are entrepreneurs, some only have one client.
And having one client is risky, because if they stop doing business with you, your income vanishes completely.
I first learned this lesson from the Personal Finance classic The Millionaire Next Door:
A professor once asked a group of sixty MBA students who were executives of public corporations this question. What is risk? One student replied: Being an entrepreneur! His fellow students agreed. Then the professor answered his own question with a quote from an entrepreneur: What is risk? Having one source of income. Employees are at risk…. They have a single source of income. What about the entrepreneur who sells janitorial services to your employers? He has hundreds and hundreds of customers… hundreds and hundreds of sources of income.
Having more sources of income lets you get away with a smaller emergency fund because your risk is partially mitigated by the fact that it’s hard for all your income to disappear at once.
How Your Own Risk Tolerance Comes Into Play
There’s a test that is usually applied to investing that works well here to: Can you sleep at night?
In other words, is worry about your financial situation affecting your life? If so, it might be best to shoot for a bigger emergency fund.
On the other hand, if you are brimming with confidence in your ability to earn money and to cut back your spending if really needed, you can get by with a smaller emergency fund.
I’d still recommend you have an emergency fund. Having a margin of safety is a pretty bright dividing line between confident and foolish.
While an emergency fund is an important margin of safety, the best margin of safety is what allows you to save for the fund in the first place: Spending less than you earn.
I once heard Morgan Housel, author of The Psychology of Money, say on a podcast that most of the time, your cash holdings seem like a needless drag. It’s only once every ten years or so that you’ll need to rely on your stash of cash, but during those rare occasions, you’ll be glad to have it.